The Contagion versus interdependence controversy between hedge funds and equity markets

This study considers the contagion versus interdependence' controversy between hedge funds and equity markets. We find that contagion effects break down the established interdependence between hedge funds and equity markets and conditional return smoothing could play a key role in the contagion process by increasing or decreasing the contagion likelihood during crisis and prosperity. It is noted that the return smoothing tends to produce a biased pattern of returns during crisis and a decreased amount of return during prosperity. These findings are obtained by linking a single equation error correction model to a factor model and carrying out quantile regression, Z-test and Wald-Wolfowitz runs tests.